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Eurozone Still Needs Its Medicine?


Image source: KeongDaGreat / Shutterstock.com

What's going on?

Prices in the eurozone are rising more slowly than they were earlier this year (i.e. inflation has fallen) – and that makes it less likely that the European Central Bank (ECB) will change its supportive policies anytime soon (see below why that’s the case…).

What does this mean?

The ECB aims for an inflation rate of just below 2%, which it thinks is normal and good for the economy. However, according to data released on Wednesday, annual inflation in the eurozone dropped in May to 1.4%, its lowest rate this year!

Some economists say this is a “wakeup call” that has shed light on outstanding weaknesses in the eurozone economy. For example, wage growth in Europe still remains relatively low: if the economy were booming, companies would be increasing pay more dramatically as they compete for workers.

Why should I care?

For markets: The ECB seems likely to maintain its extreme policies.

Inflation can be an indication of economic strength because, in a growing economy, people are typically prepared to pay higher prices for things. If inflation were increasing, the ECB would probably be more comfortable with interest rates going up (since that would suggest that the economy could withstand the headwind that higher interest rates create by making it more expensive to borrow, and thus spend, money). But since inflation is subdued, investors should see more of the same from the ECB, which has caused a relatively weak euro (why? click here) and, in general, supported stock and bond prices.

For markets: “Core” inflation is likely the key – and it’s not increasing.

The overall rate of inflation gets a good deal of attention, but economists tend to look at the “core” rate, which excludes volatile items like food and energy. The costs of those items move around quite dramatically due to changes in commodity prices and aren’t really reflective of the underlying rate of inflation in an economy. In May, core inflation fell in the eurozone, in a sign that inflation isn’t sustainably increasing (this is broadly true in the US too).

Originally posted as part of the Finimize daily email.

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